Wednesday, August 20, 2008

Put to Call Ratios and Volatility Predictions

Michael at MarketSci is out with another provocative post this morning. Focusing on the CBOE total put to call ratio (CPC) data history, he uncovers an interesting relationship between an elevated put to call ratio relative to the 50 day moving average and next day volatility in the S&P 500 index. In The Put-to-Call Ratio at Extreme Values, Michael draws the following conclusions:

“High and low put-to-call ratios…have done a pretty good job at predicting next-day volatility… High PCR levels indicate a bearish sentiment (high level of puts relative to calls purchased) and have been followed by a significant increase in volatility (+29.7%). Low PCR levels indicate a bullish sentiment and have been followed by a significant decrease in volatility (-17.3%).”

Looking at over a dozen years of data, MarketSci also concludes that the pattern has persisted over time but has been less pronounced over the course of the last two years (see chart for details).

I will leave the reader to ponder the implications of having a one day edge in predicting SPX volatility, but given how active SPX and SPY options are, there ought to be quite a few different ways to profit from this type of insight.

10 comments:

hooligan said...

Well no surprises there..there is always less "risk" from an upside move compared to a downside move..gee i wonder if it has anything to do with 100% up = 50% down..hey maybe its an inverse relationship ..d'uh

roameri said...

Dear Bill:
There is a contrarion school of thought which says that a rising PCR indicates that the bearish sentiment is reaching its saturation point. At a PCR of greater than 1.00 a reversal of a bearish sentiment can be expected.
(Your article says > many contrarians believe that the VIX and VXN are a good measure of complacency in the markets.<
What say you ?
Cheers!!!
j.

Bill Luby said...

Hi Roameri,

Sorry for the belated reply. I am still catching up from the holidays...

Regarding your question, I am one of those people who believe that a P/C ratio of > 1.00 is often a bullish signal that bearish sentiment is indeed peaking. I generally used moving averages to smooth out multi-day P/C data, but my underlying thinking is as you suggest.

As for the VIX, VXN and other volatility indices, I believe that like the P/C ratio, these are also excellent mechanisms for identifying when sentiment has likely reached an extreme and will reverse.

Of course holidays, restrictions on shorting, systemic meltdowns, etc. all can muddy the waters, but I still think the general principles are sound.

Cheers,

-Bill

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